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Will trading of rupee NDF on GIFT curb volatility?

Lokeshwarri SK | Updated on April 09, 2020 Published on April 08, 2020

It may take some time for trading to gain traction on this onshore global financial hub, but the RBI has made the right move

When RBI Governor Shaktikanta Das held the mid-term policy press conference in late March, to address the Covid crisis, he slipped in an interesting measure towards the end. He said that the time was apt to improve efficiency of price discovery in the Indian rupee and therefore banks in India will be allowed to participate in the rupee NDF (Non-deliverable Forward) market from June 1, 2020.

This measure was a little out of sync with other measures — such as the 75 basis points cut in policy rate, infusion of liquidity through TLTRO, cut in CRR and marginal standing facility or the three-month moratorium on term loans — that addressed the immediate distress in the economy. But that does not mean that the decision to allow Indian banks in the NDF market is irrelevant.

The RBI has been increasingly worried about the growing clout of the rupee trades in the NDF market and on offshore exchanges. These trades cannot be curbed because the Indian government has sovereign right over the currency, but not on currency exchange rate, which involves two currencies. With the size of the rupee NDF market growing larger than the onshore forward market, the offshore trades have begun to play a larger role in price discovery.

The task force on offshore rupee markets headed by Usha Thorat had pointed out that “the influence between offshore and onshore exchange rate goes both ways in normal times, that is, it is bidirectional…but during the last two stress episodes (the taper tantrum and the 2018 emerging markets crisis), the relationship turned unidirectional, with the NDF market driving onshore exchange rate.”

Currency markets have been in a turmoil over the past month as panic over coronavirus led to broad-based selling by foreign investors across the world. With the FPI outflow from Indian equity and debt securities hitting a record ₹1,18,203 crore last month, the Indian rupee too spiralled 5.8 per cent lower against the dollar in 2020.

With the volatility likely to persist, the RBI is probably of the view that the time is right to begin moving the control over rupee value, back to India. One way to achieve that would be to begin the trading of rupee derivatives on exchanges in the GIFT IFSC. The other is to allow banks in the GIFT IFSC to trade in rupee non-deliverable forwards.

Rupee NDF in GIFT IFSC

If the mountain cannot come to Mohamed, then Mohammed should go to the mountain. This is the strategy that the Reserve Bank of India is now trying to adopt in its battle against the rupee NDF market. Since there is no way to curb the NDF trades in international centres such as Singapore, Hong Kong, London, Dubai and New York, the RBI has decided to allow Indian banks to trade in these contracts.

But what are NDFs? These are forward contracts traded over the counter in the offshore financial centres cited above. These contracts are not physically settled with rupee, but the profit or loss is settled in a convertible currency such as the dollar.

The NDF markets have grown due to the lack of a developed onshore derivative market in some currencies, for hedging purposes. Besides this, many hedge funds and large traders prefer offshore centres for their speculative trades, thus leading to the growth of offshore NDF markets. The smart way to shift these trades onshore would be to migrate them to the GIFT City.

The RBI has permitted Indian banks which operate banking units in the GIFT IFSC (IBUs) and have the licence to act as an authorised forex dealer to participate in the NDF market from June. Banks can trade through their branches in India, their foreign branches or through their IBUs. The ecosystem in the GIFT IFSC is conducive for the launch. There are 12 Indian banks and one foreign bank with offshore banking units in the IFSC. Other foreign banks are in talks to set up IBUs in GIFT. The taxation and transaction fee is competitive vis-à-vis other offshore NDF centres.

Rupee ETCD on GIFT

The other major shift in currency markets is the launch of rupee derivatives on exchanges in the GIFT IFSC. Decks have been cleared for this product, all the rules are in place and exchanges are set to launch rupee futures and options once the lockdown period ends.

This will also greatly help towards controlling rupee volatility as volumes from exchange-traded offshore rupee markets in Chicago, Singapore and Dubai migrate to the GIFT. While volumes on these exchange platforms have typically been lower, they have wielded enormous influence on rupee pricing.

Will RBI’s strategy work?

There are definitely many hurdles that need to be surpassed before currency trading takes off in the GIFT IFSC. The primary difficulty is the ground reality that liquidity begets liquidity. Traders typically prefer platforms with large volumes where they can execute transactions with minimal impact cost. Therefore, an initial pool of traders or hedgers are needed who consistently execute big transactions.

The RBI should focus on increasing participation in the GIFT platforms by giving easy access to FPIs registered in India as well as NRIs. It’s only when volumes grow that other investors and traders, such as foreign funds, will begin considering the GIFT IFSC.

The RBI should also think again about disallowing individuals from opening bank accounts in IBUs. This keeps Indian HNIs (high net-worth individuals) from participating in the GIFT IFSC.

Dispute resolution system or arbitration process should be robust to help gain the trust of foreign traders. Lastly, the Indian regulators should avoid policy flip-flops and keep the interest of investors at heart while framing rules.

While currency trading in the Indian IFSC may take some time to take off, it is the right step from the RBI. For, this is the only way to control excessive currency volatility caused by speculative excesses.

Published on April 08, 2020

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